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AN ECONOMETRIC INVESTIGATION OF PRODUCER PRICE IMPACT ON GAS RESERVES IN REGULATED UPSTREAM SECTOR OF PAKISTAN
Faisal JamilAssistant Professor
School of Social Sciences & HumanitiesNational University of Sciences & Technology (NUST)
Sector H-12, Islamabad, PakistanPh: +92 51 9085 3556, Cell: 0333 7416577
Abstract
Upstream exploration for oil or gas reserves consists of drilling efforts for finding new reserves. The objective of the paper is twofold. Firstly, it examines the relationship of upstream activities with regulated wellhead gas price, international crude price index and economic. Secondly, we estimate the income and wellhead gas and international crude oil prices elasticity facing the E&P companies using annual data for the period 1992-2012. We find that the natural gas reserves in Pakistan upstream sector respond positively to international crude price and domestic wellhead gas price with price elasticity greater than 1 in case of gas price to reserves addition.
Key Words: Natural gas, wellhead price, error correction model, Pakistan
AN ECONOMETRIC INVESTIGATION OF PRODUCER PRICE IMPACT ON GAS RESERVES IN REGULATED UPSTREAM SECTOR OF PAKISTAN
1. Introduction
Natural gas is a relatively clean fossil fuel and its share in global energy supplies is
increasing particularly during last two decades. Pakistan relies on domestic natural gas for about
half of its energy requirements. The past studies show that country has substantial potential of
the gas resource and plenty of domestic gas would be available if investment essentially from
private sector is made in the upstream sector (Ghouri, 1996; Azad, 2011; EIA, 2011; Jamil,
2012).
Fostering the gas exploration and production is crucial for the country due to the strategic
importance of natural gas as a sustainable and clean source of energy. Many past studies analyze
the oil and gas production for different regions, countries and companies (see for example,
Iledare, 1995; Iledare and Pulsipher, 1999; Rao, 2000; Suslick and Schiozer, 2004; Mohn and
Ombundson, 2008; Ciarreta and Nasirov, 2012). Most of these studies attempt to develop
petroleum drilling and discovery models to study the impact of energy prices, taxes, risk,
resource potential and depletion and some other factors on petroleum reserve additions.
Econometric models are generally based on the idea that higher wellhead gas prices, at least
indirectly, lead to more reserve additions due to increased exploratory and development drilling
through incentivizing the investors (see, Fisher, 1964; MacAvoy, 1971; MacAvoy and Pindyck,
1973; Uhler, 1976; Ghouri, 1996; Dahl and Duggan, 1998; Farzin, 2001; Adelman, 2002;
Krichene, 2002; Ringlund et al., 2004; Jamil, 2012). These studies generally treat additions to
reserves as an outcome of upstream activity in which drilling wells is a primary input to
transform fossil fuel resources in-place into the economic category of proven reserves. Increase
in wellhead price offers to the exploration and production (E&P) companies raises their
profitability, thus improving investment prospects in the sector (Dayanandan and Donker, 2011).
Most of past studies develop models and use aggregate annual data sets to estimate stochastic
production function (see for example, Uhler, 1976). Alternative policy regimes is critical in E&P
companies’ behavior towards making investments and production decisions (see, Pierce, 1983;
Amundsen, 1991; Grigoryev, 2007; Jamil, 2012; ). The parameters of a model are likely to vary
with change in policy regimes. Companies may change how they form their profit expectations
and this eventually would change the decision rules (Lucas, 1976). In a recent study, Blake
(2013) examines the distortions caused by fiscal systems of upstream sector on the exploration
and production activities of a profit-maximizing firm through a numerical model. The study finds
that property tax is distortionary as greater levels of reserves additions increase the property tax
base hence the firm may reduce tax burden by reducing investment in reserves.
Hernandez-Perez (2011) outlines an important aspect of the oil industry that is, the inherent risk
of its activity and discus three sources of risk including, geological, commercial and political.
Managi et al. (2005) identify technological change as the most significant role in the offshore
industry through increasing reserves and lowering cost. Szklo et al. (2008) evaluates the
alternative strategies of producing oil from discovered fields with proved reserves to find
opportunity cost of delay and find that opportunity cost of delays is so high that higher than 10
years delay require break-even price to values between US $200 and 350/bbl.
Our study is based on annual data for the upstream sector of Pakistan for the period 1992-2010.
The elasticity estimates help to explain the impact of price incentives. This paper develops an
econometric model to explain the gas discovery process and reserve accumulation.
2. Natural Gas Exploration and Production in Pakistan
In order to set the scene for our empirical analysis we start with giving a brief overview of
petroleum policies, wellhead prices of natural gas, production, sector-wise gas demand and
reserves (Planning Commission 2011, PIPS, 2008).
Figure 1: Growth Trends of Total Energy and Natural Gas Supplies
19861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008200920102011
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
Total
Gas
Million T
OE
Institutional setup
It seems useful to begin with a summary of the salient features of the present regulatory system
imposed by the Natural Gas Act (NGA) and the Petroleum Policy (NGPA). Gas systems are
operated in similar manner where natural gas flows from wellhead to pipeline to distributor and
finally to consumer. Ministry of Petroleum and Natural Resources (MPNR) through its
petroleum policy offers gas price to the E&P companies. The produced natural gas is distributed
by two public utilities namely, Sui Northern Gas Pipeline Limited (SNGPL) and Sui Southern
Gas Company Limited (SSGCL) operating respectively, in the northern and southern parts of
Pakistan.
Demand, supply and shortages
Literature on gas shortage in terms of it causes and effects have widely been studied. There are
political consequences of natural gas shortage. The gas production, contract sales at the wellhead
and distribution to consumers are strictly regulated and controlled by the Ministry of Petroleum
and Natural Resources (MPNR). Therefore, the government becomes focal point for complaints
that regulatory policies have either caused or failed to improve the looming gas shortages. The
political loss for the office bearers is substantial since neither producers support the regulatory
process nor consumers benefit from the shortage.
3. Theoretical and Estimation Framework
Accumulated reserve additions of natural gas depends on in particular, the resource availability
and economic and policy incentives along with geological and engineering capability.
Nonetheless, drilling outcomes are stochastic in nature. Drilling effort inevitably varies with
economic incentives, effective tax rates, and market conditions (Iledare, 1995). Siliverstovs et
al., (2005) explore the relationship between international gas prices in relation with crude oil
price and finds that market power of regional suppliers is large in case of gas as currently gas
traded regionally. On the basis of simulation and partial equilibrium model on energy industry in
the US, MacAvoy and Moshkin (2000) find that there is a significant negative trend in the long-
term price of natural gas at the wellhead. The natural gas market slightly differs from a typical
spot market as the supplies are based on the sale of reserves. The E&P companies drill either
exploratory wells or development wells based on prospects of success. The study adopts a
modeling framework considering natural gas reserves as primary means of gas production. Both
of gas reserves and production depend on resource availability, economic conditions, policy
incentives, geological knowledge and engineering capability. Implicitly, reserve additions (the
measure of drilling outcomes) depend upon these factors as well as the stochastic nature of
drilling outcomes. Given the conditions, reserves addition in gas supply is greater when E&P
operations rise. The E&P or more specifically drilling activity essentially depends on regulated
wellhead petroleum price to the companies.
wells drilled, share of successful wells, average reserves per well, or total reserve equations.
Therefore, we model the accumulated drilling as a function of producer price and real economic
activity as,
R = f(Gp, Op, Y)
Higher estimates of income and oil price elasticities would imply a larger impact of international
crude oil prices and economic activity on drilling in domestic upstream sector in the long run.
The theory predicts that producer price is an important determinant of investment in E&P
activities. This study adopts the widely used Johansen Maximum Likelihood approach. As a first
step, we check the stationarity of the series by employing the Augmented Dickey-Fuller (ADF)
and Phillips-Perron (PP) tests. These tests identify the order of integration of each series (Dickey
and Fuller 1979, Phillips and Perron, 1988).
Non-stationary variables are generally modeled in their differenced form to induce stationary.
Since the long-run relationships are lost if variables used in their first difference, hence, it is
pertinent to conserve the long-run information contained in level variables and at the same time
ensure stationarity so as to avoid the spurious regression. Cointegration helps in meeting both
these seemingly contradictory objectives. Thus, we employ Johansen method to cointegration to
the series of the same order of integration in the second step. In the third step we estimate a
vector error correction model (VECM). A VECM identifies and characterizes the cointegrating
relationship among variables. The relationship is measured at the level of each time series
variable. The model accounts for changes in each variable as a function of past changes in the
variables. This is done to capture the effects of long-lived shocks to the series. Gas and crude
prices are used in the model as exogenous variables because we theorize that crude oil and
wellhead gas prices are related to exploration activities carried out in the country. Hence, we
would like to see whether changes in exogenous variables provoke changes in the endogenous
variables. The ECM measures the rate at which the time series returns to the cointegrating
relationship when a shock cause it to deviate. So a VECM has two main components, the lagged
variable changes (the shocks that push the variables away from their long-run relationship), and
the error correction vector (i.e. the rate at which each of the variable is pulled back to its long-run
relationship). The VECM models the relationship between crude oil and natural gas prices and
exploration activity. We are interested in identifying how crude oil and gas prices are affecting
the exploration at the upstream. Gas prices in Pakistan are regulated and determined based on the
public policy.
Literature shows that economic incentives (primarily determined by the international crude price
and wellhead gas price) are important in determining private investment, proved reserves,
exploration, and production. Producer price of petroleum is taken as an explanatory variable
since, it appears effective in adjusting investment decisions of private E&P companies in
exploring and producing from new fields (see for example, Farzin, 2001; Ringlund et al., 2004).
Petroleum output for example, oil that is sub-economic at $50 per bbl may become profitable at
$70 per barrel. Therefore, at a sufficiently high price, regions with much poor prospects may be
considered by exploration companies for drilling test wells (Sterman et al., 1987).
Mulder et al.,(2004) find that long-run average of the oil price is significant in explaining the
level of explorative as well as development drillings. If drilling equation results indicate that
wellhead price has strong influence on accumulated reserves, one may expect that long run price
elasticity of drilling oil and/or gas to be greater than 1.
Variables description:
Total number of wells drilled (Exploratort + Development/appraisal wells) - W
International crude oil price - Op
Producer price of gas - Gp
Real GDP - Y
4. Results and Discussions
Our empirical analysis is twofold. Firstly, we estimate the long run elasticity of reserves addition
to the wellhead gas and international crude price and overall economic activity in the country
using the annual time series data. Secondly, we applied the Granger causality test to check the
direction of causal relationship (if there exist any), among the variables.
As a first step of empirical analysis we checked the unit roots since many macro level series are
found non stationary. We applied Augmented Dickey-Fuller (ADF) test for checking stationarity.
Table 1 shows that all the three variables are non stationary at their levels and become stationary
in their first difference. In the next step, we employed Johansen test for cointegration. The same
methodology provides estimates of the cointegrating vector. Table 2 provides the evidence of
one cointegrating vector.
The existence of cointegration implies that causality in at least one direction exists. The direction
of causal relationship can be detected through vector error correction modeling. In the third step,
we estimate the error correction model. In addition to providing an indication of the direction of
causality, the ECM distinguishes between short-run and long-run effects. Results of ECM are
given at Table 3. The results indicates that crude price and producer price of gas Granger cause
total annual number of wells drilled in the country. In the short-run, only gas price is found
affecting the number of wells drilled without feedback.
Table 1: Results of Unit Root Test
VariablesADF Philips-Perron
Level First Difference Level First Difference
W -1.62 -4.98a -1.75 -6.39a
Gp -0.27 -6.99a -0.57 -7.56a
Op -0.59 -4.76a -0.47 -4.97a
Y -0.32 -3.43b -0.33 -3.43b
Note: The regressions include an intercept. All variables are in natural logs. Superscripts a and b indicate the significance at 5 and 10 percent.
The estimated cointegrating vector of ECM also gives the elasticities as follows.
ΔW = 1.59 - 1.23Y + 0.47Gp + 0.75Op Adj. R2 = 0.88 (3.75) (3.51) (6.94) F.Stat = 23.46
Table 2: Johansen’s Cointegration Test
Rank (r) Trace Statistic Eigenvalue
0 50.22*
(47.85)
29.14*
(27.58)r 1 28.96
(29.79)18.03
(21.13)
r 2 11.32(15.49)
10.42(14.26)
r 3 1.46(3.84)
1.46(3.84)
(a) r denotes the number of cointegrating vectors.
(b) The figures in ( ) are MacKinnon-Haug-Michelis critical values and [ ] are t-values of coefficients.
(c) The cointegration test results are at lag interval one in the first difference.
* denote rejection of null hypothesis of no cointegration at 5% level.
The final estimated model behaved well in statistical terms. All parameters are highly significant
as indicated by the standard deviation in the parenthesis. The coefficients of regulated producer
gas price and international oil price are statistically significant and the equation explains 86% of
the variance in discovered reserves. It shows that if wellhead gas price increased by 1%, total
number of wells drilled will rise by 0.47%. Similarly, a 1% increase in crude oil price will result
in 0.75% increase in drilling activity. This is justifiable since regulated wellhead prices of both
crude oil as well as gas in Pakistan are linked with international crude price. The
coefficient/elasticity of crude price is significant at 1% whereas, it is significant at 10% level in
case of gas price.
Table 3: Results of Granger Causality through Error Correction Model
Variables ECT(t-Statistic)
Short-run effects (F-statistic)ΔW ΔGp ΔOp ΔY
ΔW -3.66* - -2.50 1.29 0.09
ΔGp 0.63 0.81 - -0.87 0.18
ΔOp -1.05 -0.61 -0.28 - 1.39
ΔY 0.29 0.06 -0.25 -0.17 -
5. Conclusion and Recommendations
Specificity and irreversibility of investments made in energy sector alongside incomplete information is the mainstay of the petroleum industry. Price uncertainty, financial risks and heavily regulated structure of upstream sectors in less prospective countries make it hard to raise the E&P investments. This paper analyzes the impact of low wellhead producer gas prices over the past decade. A phenomenal drop in reserves addition vis-à-vis rising demand for domestic gas have led to the beginning of a gas shortage in Pakistan. Pakistan has sufficient unexplored potential of domestic natural gas production but the E&P activities do not pose a sanguine outlook at least in near future. The upstream sector is regulated and past studies clearly shows
that wellhead gas price offered to the companies has proved to be quite phenomenal in incentivizing investment. Postponing the onset of gas price increases can therefore be achieved more effectively through efforts to reduce demand growth (Chi et al., 2009). Stern (2002) investigates the impact on security of supply of increased gas import dependence and liberalization by looking at the four different components of security framework namely, reserves and reserve-to-production ratios, long-term contracts and multi-billion-dollar investments, import dependence, and emergency security events, all of which may be affected by liberalization and competitionA pragmatic gas pricing policy can help the economy to obtain certain objectives, which can be summarised as follows:1. Encourage new investments especially from private sector and to raise domestic gas reserves;2. Ensured sustainable supply of gas to the regions and sectors where infrastructure is there; 3. Ensure stable availability and price signals for long gestation investments based on gas;4. Appropriate price signals for efficient use of gas.
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